With the exception of the MegaUpload flap a year ago, Cogent had a rather quiet year in 2012, selling the usual tons of bandwidth at low prices, building out to both new markets and additional buildings, and of course weathering Hurricane Sandy. The market certainly liked it as the company’s stock price rose 35% on the year and has continued to rise since. Cogent has always had a unique, tightly focused, and lately entirely organic approach to the bandwidth business. Here to give us an update on where the company is and where it’s going in 2013 is CEO Dave Schaeffer.

TR: Cogent has greatly expanded the geographical reach of its network in recent years, but lately you have suggested that the pace of expansion will be slower. What’s changing?

DS: Today we're in over 180 markets in 36 countries and our network encompasses more than 56,500 longhaul fiber route miles and about 26,500 miles of metro fiber. While there are probably a few additions we'll do, there aren't many because many of the countries that we would wish to extend into either don't have infrastructure available for purchase or have a regulatory climate that doesn't work with our business model. And finally, a lot of countries just don't have enough aggregate demand to justify the extension of our network.

TR: You have also been steadily expanding your on-net building count, will that also be moderating?

DS: In our global footprint we connect to about 625 data centers in about 550 unique buildings, and we're going to probably add another 50-60 data centers annually to our footprint globally, since that seems to be about the pace at which carrier neutral facilities are being constructed around the world. The other piece is the multitenant office building footprint we connect to in North America. We're in about 1,300 of those today, but our buildings look very different than the general population of buildings. They tend to be very large, with about forty stories, 550,000 square feet, and have 50 unique tenants. We'll add another 50-75 such corporate buildings over the next year and then slow down at that point. We're kind of running out of additional targets that fit our criteria.

Today in our corporate buildings we have about 10.4 customers per building out of about 51 opportunities, and we add about 1.8 additional customers per year. So we look at that ramp, our cost of acquisition, and our capital costs and really can't justify going after smaller buildings. A lot of fiber companies don't generate free cash and are focused on growth and growing the footprint. We are focused on growing profitability.

TR: Your corporate-centric business has been limited to North America. Is there a similar opportunity in Europe that might become attractive, or is the situation too different there?

DS: It really is very different. In North America there are about a million commercial buildings. In Europe there are about 1.4 million. But the issue in Europe is that most of the buildings are either much smaller or have many fewer tenants. While there are probably 100-150 skyscrapers across the continent -- a much smaller number than in North America, almost all of them are single tenant buildings. There really isn't a multi-tenant skyscraper bandwidth opportunity in Europe.

TR: Over the past few years, Cogent hasn’t participated in the wave of consolidation that has swept the industry. Has your outlook on M&A changed at all?

DS: We look at numerous opportunities globally, not just North America and Europe but Asia too. We probably review 150 opportunities each year, and we're willing to look at lots of different business models to bolt onto ours. We have a two-part filter for M&A. The first test is whether it is cheaper to buy the whole business than the assets we want. Most of our past acquisitions have fallen into that category. The second is that we'll look at different business models to buy if we can generate free cash and a return on capital greater than our cost. We're even willing to buy businesses in decline, they just have to be priced appropriately. Whether it's managed hosting, VoIP, disaster recovery, video distribution, quite honestly everything in our sector is dramatically overvalued on a free cash flow generation basis.

TR: Are asset prices more favorable in Europe?

DS: While valuations can be slightly better in Europe than in North America, I believe they are still are too expensive on a discounted free cash flow basis.

TR: Many network providers around the world have been announcing plans to upgrade to 100G. What is Cogent’s view, is it time yet?

DS: Today if you look across our 56,500 miles of longhaul fiber, we have an average of about 60 10G waves lit. The technology we have deployed is capable of 160, so we have additional wavelengths available. 100% of our longhaul capacity is plugged into routers, so it's all layer 3 capacity. We do have some 40G waves on select routes, and we have tested and deployed limited amounts of 100G. But 100G transport is still more than 10 times as expensive as 10x10G. So it's really just driving down the cost per bit mile that we’re waiting for. And we will absolutely embrace 100G when and if it makes sense.

TR: How far away are we from the point where 100G transport really comes of age?

DS: My gut feeling is that we're probably still a year and a half to two years away from widespread deployment, complete stability, and hitting the price crossover point where it's actually cheaper to use 100G than multiple 10G waves.

TR: You have said that the effects of Hurricane Sandy will be negligible in financial terms, but how did Sandy affect Cogent in New York City operationally?

DS: Below 34th street Con Ed turned off the grid. At the peak we had about 80 on-net buildings without power. In our multitenant buildings we generally have four hours of backup battery, and since ConEd had that part of New York dark for more than four hours we did lose those but of course there were no tenants in them during that time. When the power came back up we had 13 buildings that had sustained physical damage that didn't come back up with Con Ed. Each is a different story, but today all but one has been restored – and that building remains completely unoccupied due to flood damage. We also have a Cogent-owned data center at 33 Whitehall which sustained significant damage. That building operated off of generators for weeks, but is back on the grid now.

TR: Recently there have been some flare-ups between content and last mile providers in France, in which Cogent’s name came up. Can you tell us what happened?

DS: We have the largest access network operators other than France Telecom as customers. One of them, Illiad, has been having a dispute with one of our other customers, Google. We are a transit provider to both parties. It appears each of them were restricting traffic from the other, but what the customer does with the bandwidth is their own business. We were named because we're in the middle, but there was no dispute between Cogent and either of them.

TR: Last mile operators have been increasingly vocal about being compensated for over the top content, how do you think it will turn out?

DS: There continues to be a concern among a lot of the major access providers around the global internet in that they aren't adequately charging their customers for the service they're selling. So they're trying to find subtle, or not so subtle, ways to diminish the quality or amount of internet traffic that gets to those customers in large part to steer their access customers into buying proprietary products. You see that in both the U.S. and in Europe. I'm a firm believer that the internet is the future and is so much more efficient than other networks and provides the end user so much choice that the long term trend is for the internet to cannibalize all other telecommunications products and services. The end result is that users get more for less. But ultimately it's going to be a combination of regulatory and consumer pressure that preserves the integrity of the internet.

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17 Comments So Far

This tiny organization–a gnat by revenues compared to peers to be sure–with nose bleeding multiples that are being ascribed to all of its business metrics is looking at 150 opportunities per year, even including non core business models to “bolt on,” but can’t find anyone or anything to buy across the globe?

It seems to me that the finance team being paid to kick the tires of all these enterprises is a waste of shareholder capital and should be “downsized” forthwith.

This is NOT a “buyer” of essential communication assets, rather, this a seller, but as Mr. Schaeffer points out, his stock price is too damn expensive to garner interest. imo

Congrats to Dave and the Cogent team. Cogent’s sweet spot is considered one of the most competitive areas of telecom. Many chaffe at “wholesale Internet”, using the word commodity to imply how it is near-impossible to make an appropriate ROI. Yet, Cogent does well quarter after quarter. Their strategy is focused, and their execution is tight. Kudos!!

Dan– I’m somewhat surprised that you would disagree with CarlK. He is well thought of around these parts in terms of deep industry insight (and conspiracy theory).

Cogent seems to have a cost advantage to the industry in general given their extremely low historical basis in assets acquired back in the bubble crash. That, along with an advantaged deal with Cisco, and a singular focus on data only, seems to let them price at a discount and still make great margins. An acquiror who slowly repriced the existing book of business could get an attractive ROCE even at what might appear to be a high price. Yes?

Ah yes, Dave Schaeffer is a seller not a buyer, and you can repeat that after me 150 times over and over again until it happens, so maybe Dan Caruso should take The Plunge or is it the “chaff” off in order to get to the more grainy pricing with substance which they continue to forgo.

After all, if Super Dan messes up by overpaying, Enron’s friends on Wrong Street where conspiracies and insider trading are commonplace, won’t be able to take him out to their WOODSHED like CRAMER and “SELL, SELL, SELL!”

However, he will be left to deal with his “investor group,” and possibly “delay” some inevitable IPO which they may be coveting in order to utilize as part of their “exit strategy.” imo

What’s interesting is that, I am sure if Mr. Schaeffer’s company wasn’t being priced for perfection as part of Heaven by “Mr. Manipulator,” inclusive of his nose bleeding premium, he would be doing The Dell Thing and taking his company private so that this spectacular business that he owns could INURE exclusively to his benefit along with his core underlying owners. imo

zayo is already digesting its LBO. they used leverage to take AboveNet private at a multiple that was above what the market valued the company to be worth. in an effort to keep ROIC where investors want it, they levered up the company, not unlike mr dell. and not unlike the CTL leveraged roll up. but i am still waiting for someone, anyone to show me an example of successful leveraged roll ups in telecom….

You rambled on some, with a lot of comments. Let me focus on only only two. First, you imply that managements only measure themselves on EBITDA generation and the same hold true for those who look at the company from the outside. That is simply not the case, and I would imagine that you have never been to an internal management meeting or board meeting focused on ops/financial metrics/CapX level/ project ROI/hurdle rates/etc.

There are many ways to manage a business and this is very true in telecom. It is a SYNTHESIS of capital allocation, product focus and marketing, incremental ROI requirements and many other factors/metrics. EBITDA is a by product of all this and is/should never be looked at in isolation. It’s just one number albeit an important one but must be looked at in context:

— how much CapX has been spent and needs to continue to be spent to generate that EBITDA and FCF level.
— different models (TWTC v’s CCOI) require very different spending rates given different product focuses and business models. Neither model is necessarily better per se, but as history has shown both companies can grow EBITDA rather nicely and consistantly with good margins
— EBITDA alone is not the story. At the end of the day it is FCF per share, and even then that depends where the company is on its growth curve– early on when Capital spending is heaviest, FCF is scarce, but later (CCOI) when the platform is maturing FCF should come or something is wrong.

Second, you are clearly not a fan of financial leverage. This is however a basic part of the financial management tool kit that allows for accretive acquisitions and serves the equity holders in maximizing ROE. Zayo has deployed it and their owners are obviously on board with that strategy (if it is worthy of the word “strategy”, it’s so basic). Overdone, leverage is dangerous but if deployed in the “Goldilocks zone” then the effects can be great for the owners.

Zayo seems to be on a roll and seems to be managed very well– how else can you integrate seemingly hundreds of acquisitions without screwing up? ABVT is a far bigger mouthful however and that will probably tell the story of how successful the investment will be. Since I was an ABVT shareholder, I was in support of the price paid and thought it reasonable. I also wish Zayo every succcess in getter where they want to go and, apparently unlike you, have no agenda that causes me to be cynical or question anyone’s motivations.

I was with MFS when it was acquired by Worldcom. I remained with the combined company in a senior executive role. I left on my own 7 months after the acquisition. The day I left, I sold all my stock because I had visibility into the inner-workings of the numbers. I saw they were focused on accounting results and manipulations, not on true value creation. I called it a “House of Cards”. After I sold my stock, it doubled in price and I felt like an idiot. Then I watched it drop to zero, and felt a tad better. I’ve made a lot of good and a lot of bad decisions in my career –the one I am most thankful of is my decision to leave Worldcom.

I had countless friends that were affected by the telecom meltdown. Seeing the stress it caused them and their families was life altering for me. I also witnessed first hand the many abuses of management and investors – who focused on story telling and accounting gamesmanship instead of long-term value creation.

I cannot guarantee what will happen at Zayo. However, I can give my assurance that we are 100% focused on fundamental equity value creation for our stakeholders. We know the path to excel is to be an exceptional supplier to our customers. We include our employees amongst our stakeholders – and the majority are benefiting financially and professionally beyond what they experienced before. Some of the newer additions might not be on board with this yet, but I suspect most will be by the middle of 2013.

Nearly all employees participate in our quarterly bonus plan. The payout level is tied to the pace in which we are creating equity value for our stakeholders. When they approve >100% payout, which has been the case in recent quarters, it is because they are pleased with the performance of the Zayo team.

What do I mean by equity value creation? Each quarter, we estimate the Enterprise Value of Zayo. To estimate, we use public comps of similar companies and valuation of recent transactions like the Lightower/Sidera merger. We use 9X LQA EBITDA. By comparison, Lightower was valued at 12X and Sidera at 8X in their recent merger (as best as I could deduce from bankers). Abovenet acquisition suggested a 9.5X, Cogent currently trades ~12X, TWT at ~9X, and LVLT ~8.5X. So 9X would seem to be reasonable.

We then subtract our net indebtedness (“Net Debt”) from the equity value. Net Debt gets smaller each quarter if the business is generating cash. It gets bigger if cash is being consumed. Therefore true cash flow performance of the business is an integral part of the calculation.

The difference between Enterprise Value and Net Debt is Equity Value. That is, it is the value of Zayo’s equity at the end of the quarter. It is what our equity holders would receive if the company was sold at 9X LQA on the last day of the quarter.

We then compare the equity value calculated from the recent quarter to the prior quarter(s). Let’s say Equity Value went up by 10% compared to the prior quarter. That would mean the Equity IRR was 40%. This would be an excellent performance by any yardstick.

One quarter could be an anomaly. However, if 40% is sustained quarter over quarter, investors would be thrilled. This would be the same as you investing $10,000 in the stock market and, one year later, it is worth $14,000.

Using this methodology, Zayo’s performance has consistently hovered around 50% IRR. (As an aside, this is only methodology that matters to equity investors).

I’m sorry you have a negative opinion of Zayo. All I’d ask is that you take the time to understand our financial performance before opining on it. We are extremely transparent with our numbers. Our earnings call is this Friday, and our detailed Earnings Supplement will be published prior to the call. I encourage you to listen in. If you have questions afterwards, please shoot me an email.

I know making money for investors isn’t the only responsibility of a corporation. We use the word stakeholder, not investor. Stakeholders = customers, employees, debt holders, and equity holders. For equity owners to do well over a long period of time, all other stakeholders must be taken care of.

At Zayo, we are striving to build a very successful and sustainable Bandwidth Infrastructure company. We think long term, but we strive to earn our stripes by producing good results every quarter. Like everyone, we make mistakes. We do our best to learn from them and improve.

Interesting that someone would point to KOH as the voice of reason and direction when running a Telecom Company.Time heals all wounds I suppose. I am a KOH fan but using his interviews and comments as path forward model if you are a telecom may be premature. Integra story is just beginning may want to see how that goes before KOH is annointed.

When he told me that Level 3 was “too hard to figure” nearly two years ago, he had to have this in mind knowing what wealth destruction that their prior seven acquisitions had caused, at the same time you point to the lowest “public market multiple” which they carry in your example.

Thank you for illustrating his point, as Wrong Street who consistently props up the values of under dogs in the space in order that they be swallowed by bigger players; continues to remain the main source of the problem of playing by their rules, and marching to their drum beat!

By the way, Enron, why didn’t you let board members here know that, your Cogent gnat is now dominating Africa with respect to rankings of internet traffic on pages 64-65? Congrats to that free loading P2P player! imo

Read very carefully what KOH and David Schaeffer are saying about profitablity, cash flow, acquistions and even counting towers the same as commercial buildings in their interviews. Both are minimizing EBITDA and focusing on true profitability. The opposite of Zayo’s Bankers before Customers creed.

Zayo bought AboveNet at a 9.1x Ebitda multiple but they then used a scourged earth campaign to reduce the multiple to 6.9x. Management then collects their christmas bonus for reaching an EBITDA goal, none of which was achieved via honest hard work, or profitability. Once this occurs middle managers on up, as a group, see this as an easier yearly strategy to receive their bonus and promotions then working for the best interest of customers and long term investors. True profitability becomes a secondary focus. Zayo is following the same business strategy (minus the illegal stuff) which lead the CFO of Worldcom to start snorting coke immediately after waking up each morning and the CEO of Level 3 to continue to tell us each year for 15 years the next acquistion is going to be the next big thing meanwhile going on 15 years without returning anything to shareholders. Note how he does not reduce his ownership stake, as he continues to increase his sharecount to compensate for each yearly shareholder destruction. Dan Caruso will do the same.
It gets the managers their bonus but it doesn’t work in the long run as it ignores the profitability, cash flow and balance sheet that the CEO’s of both these interviews are focused on. Zayo, Level 3 and Worldcom managers talk EBITDA only numbers since EBITDA is operating profit ignoring the true financial decisions (in other words it allows managers to use financial engineering instead of improving customer products). The Bankers understand this but their goal is to get future investors to ignore.

Level 3 (rebrand themselves as Global Crossing) and Zayo (rebrand themselves as AboveNet) are now both performing the second stage after the scourged earth campaign, trying to rebrand themselves with positive press releases for actions that did not occur under their watch. Level 3 is putting out press releases which were performed by Global Crossing with no input from them. Zayo just put out a press release saying they were involved with the presidential party celebration which clearly could not have been done by Zayo’s current management team plus they have increased the amount press releases over the last couple of months which are probably in the same boat. All an effort to rebrand themselves without doing the work.
In Level 3 case the roll up has has never worked, In Zayo’s case because it is highly leveraged they will attempt to screw over future investors in an IPO and the bankers will be successful selling to the bigger fool but anyone paying more then 6.8x EBITDA in the public IPO is going to get screwed big time. Just ask anyone who bought Level3 or Worldcom at a higher multiple then 6.8x EBITDA how much cash they got back!

There is a reason that Warren Buffett recently was asked if he would name a private equity investor he would recommend and he said he could not.

For as much attention as you pay Zayo, you don’t seem to know what you’re talking about. I suggest reading Zayo’s earnings supplements. The company is the most transparent in the industry. With as much information as Zayo releases, it would be pretty damn difficult to achieve these results without “honest hard work, or profitability.” Feel free to skip the EBITDA numbers and jump straight to CapEx-IRUs, and then reconsider whether Zayo cares about FCF and is run in a way that maximizes it.